Fair-Value Accounting's "Atmosphere of Fear"

Scared stiff by auditors, banks have been operating in a "lockdown" in the use of individual judgment, senior finance executives say.
David M. Katz, CFO.com | USMay 19, 2008

Senior finance executives at some of the biggest financial institutions are calling on the Financial Accounting Standards Board to reassess its new fair-value standards in light of the banks' experience in the subprime crisis.

The shift to fair-value accounting in the midst of the crisis spawned an "atmosphere of fear" that lead to a "lockdown" in the use of judgment in valuing securities, they said last week at a Standard & Poor's conference provocatively titled "Is it Time to Write Off Fair Value?"

While broker-dealers and other market-makers had systems in place that they could use to mark their assets and liabilities to market, others were caught empty-handed when asked to mark instruments to markets that had suddenly dried up, according to speakers at the conference, who provided a vivid early picture of what life has been like for senior finance folks as they tried to adopt to new disclosure requirements in the midst of an extreme credit crunch.

The climate lead auditors to adopt a hugely conservative approach to their clients' valuation of securities, the executives said. And that lead to huge write-downs, investor confusion, and excessive earnings volatility.

One part of the controversial new mark-to-market standard, FAS No. 157, Fair Value Measurements, that needs a second look is a provision that says that market prices must be assessed on the basis of market participants that are "willing" to buy or sell the asset or liability but are not "forced or otherwise compelled to do so," according to Bob Traficanti, head of accounting policy and deputy controller of Citigroup.

Traficanti, a former FASB project manager who worked on FAS No. 133, the board's hedge-accounting standard, suggested that some of the prices that the bank had to come up with indeed felt coerced. One of the "unintended consequences" of the new rules has occurred at Citigroup "in situations where we have securities with little or no credit deterioration, and we're being forced to mark these down to values that we think are unrealistically low," he said. "I would ask the FASB to ... back-test to see how this really worked."

Similarly, Christopher Hayward, a Merrill Lynch senior vice president and finance director, asked FASB to go back and look at the results of the standard with an eye to the "almost borderline panic" that beset many companies at the prospect of gauging the fair value of securities with no semblance of a market. Many firms in the financial-services industry lacked the models to create hypothetical markets when the real ones dried up, he added.

But not only the financial firms were unprepared, Hayward said. Their auditors also found themselves fumbling in the dark. As result, the Merrill executive said, they advised their clients, "Let's just mark [an asset or liability] down; there's no question if we mark it down heavily."

The intense conservatism that ensued eclipsed the role of judgment in marking instruments to market, according to David Johnson, the outgoing CFO of the Hartford Financial Services Group. He called papers issued last fall by the Center for Audit Quality (CAQ), an offshoot of the American Institute of Certified Public Accountants, "basically a shoot-to-kill order for anyone who would exercise judgment."

Arguing that putting valuation judgment in the hands of financial-statement preparers would create a moral hazard, policy makers proposed that "Mr. Market" should be the source of valuations, he said. "But when things didn't go well, the approach was to put everything in lockdown."

Disputing the effect of the CAQ papers, Ray Beier, a PricewaterhouseCoopers partner, retorted that the subprime losses would be on balance sheets in any event. Observing that "the whole concept of second-guessing is alive and well, not just in fair-value value," he said that "market values would be low, regardless of 157, regardless of the element of conservatism."

To cope with the knee-jerk decision-making that he sees as the spur to the big write-downs, The Hartford's Johnson proposed that the Securities and Exchange Commission, the Federal Reserve, and/or nongovernmental organizations provide an information clearinghouse companies could use derive prices when there are no markets.

Despite their criticisms of the reaction to 157, the senior finance executives all sung the praises of fair value. "We support far-value accounting, we think it's relevant, we think it's meaningful," Citigroup's Traficanti said. "Certainly part of our business is broker-dealer, and we spend a lot of time valuing instruments.

Indeed, as Robert Herz, the chairman of the Financial Accounting Standards Board pointed out, it was a group of financial institutions that in 2006—in the midst of a much more favorable securities market—came to FASB asking for the choice of using fair value. Previously, companies used a "mixed-attribute" accounting framework in which some assets and liabilities were booked as historical cost and others fair value.

By 2006, however, the banks wanted the choice of marking the risks of certain assets, liabilities, and derivatives to market as a whole portfolio—
a choice that companies operating under international accounting standards had. In that way, they could manage the risks of the entire portfolio so that each instrument could offset the risks of the others. Until that time, under hedge-accounting strictures, they had to go through a complex process of measuring "hedge effectiveness" when handling the risk of a derivative separately.

Thus, in February 2007, FASB gave companies the choice to use fair value in measuring the worth of many of their instruments. Under FAS 159, they can apply fair value instrument by instrument, although their choice to do so can't be revoked. And the rule made sure that companies marked the whole instrument to market. "They couldn't just cherry-pick when to recognize the upside of the stock," Herz said.

In that first quarter of 2007, when many major financial institutions and smaller ones chose the fair value for parts of their balance sheets, they were "all extolling the virtues [of] those elections," Herz pointed out. Apparently, many are singing a different tune now.